The Limitation of Balancing Funds

The purposes of balancing funds in Indonesia includes strengthening subnational governments’ fiscal capacity, reducing fiscal disparity (i.e. fiscal capacity inequality) between the central and subnational government and among subnational governments, improving the quality of public service, and reducing the gap in public service among regions (Ministry of Finance 2011). In public services delivery, the unconditional grants component in balancing funds functions as equalization grants, which aim at reducing fiscal disparity among local governments. Equalizing local governments’ fiscal capacity arguably enables local governments to provide comparable public service at comparable tax rates (Broadway 2007). The conditional grants, on the other hand, provide funding for specific public service to improve it or to promote the achievement of a certain standard (Broadway 2007, Slack 2009). The importance of equalization is based on the premise that all people in a nation are entitled to a reasonably similar standard of public services provided by governments (Ahmad et al. 1999).

This section will evaluate the effect of DAU, DBH, and DAK as individual components and as systems on local governments’ fiscal capacity inequality, or fiscal disparity. Local government is the focus of this analysis because public services are devolved to local governments; therefore their fiscal capacity is important for public service provision.

The fiscal disparity is measured by the Coefficient of Variation (CV). CV measures variability in relation to the mean and is used to compare the relative dispersion in one type of data with the relative dispersion in another type of data. CV can be used to measure the

equalizing effect of grants on fiscal disparity, with lower CV indicating reduction in fiscal disparity (Blochliger 2007).In this analysis,CV is calculated in 4 steps to observe the change in local governments’ fiscal disparity with the addition of each balancing fund component.

a. CV is calculated based solely on own-source revenues per capita (OSR).

OSR of a local government consists of local taxes, local retribution, profit from subnational enterprises, and other OSR (e.g. interest revenues and donation). It is the most relevant indicator of a subnational government’s capacity to generate revenues by its own efforts.

Thus using OSR can highlight the difference in fiscal capacity between subnational governments.

b. CV is calculated based on OSR and DBH per capita (OSR+DBH).

Unlike OSR that depends on local governments’ efforts to generate revenues, DBH mainly arises as a result of regional advantage which can provide additional revenues. Regions with favorable conditions to generate taxes and regions rich in natural resources benefit the most from DBH, since the formula of DBH favors such regions in the sharing of revenues.

Therefore, DBH significantly strengthens the fiscal capacity of such local governments. The impacts of the increased fiscal capacity will be evaluated in this section.

c. CV is calculated based on OSR, DBH, and DAU per capita (OSR+DBH+DAU).

The unconditional grants DAU are also equalizing grants. The effects of DAU will be evaluated by observing the change in fiscal disparity (which have been calculated based on OSR and DBH), after including DAU in the figure.

d. CV is calculated based on OSR, DBH, DAU, and DAK per capita (OSR+DBH+DAU+DAK).

In recent years, DAK has become more fragmented as more subnational governments receive DAK funding and more sectors are regarded as national priorities. The coverage of DAK is widening, but with smaller amount. This may indicate that DAK has lost its

specificness. The last step of CV calculation tries to answer whether DAK, considering the fragmentation and widening coverage, has shifted from its original role as conditional grants, which provide capital investment assistance to selective regions in specific sectors.

The result of the CV calculation for local governments’ fiscal disparity is summarized in Figure 5.5 below.

From Figure 5.5, it can be observed that fiscal disparity between cities/regencies originally exists to some degree when only OSR is considered as local revenues. Fiscal disparity then increases with DBH allocation, and decreases after DAU allocation. This is not surprising since DAU is meant to be equalization grants. When DAK is allocated, fiscal disparity decreases even further.

The interesting point is the reduced fiscal disparity as a result of DAK allocation. DAK is a specific grants financing capital investment; it has some specific purposes, but equalization is not one of them. Yet, the graphs show that the contribution of DAK to reduced fiscal disparity becomes more evident over the years. In 2001 and 2002, the contribution of DAK to reduced fiscal disparity is very small. Between 2003 and 2010, the gap between CV with OSR+DBH+DAU+DAK and CV with OSR+DBH+DAU is widening, suggesting that the impact of DAK on reducing fiscal disparity becomes more obvious.

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010

OSR 1.7258 1.5368 1.4225 1.4855 1.6025 1.5591 1.5441 1.5740 1.6188 1.7175

OSR + DBH 1.8062 1.8032 2.0639 1.4809 2.0761 2.1282 1.9071 2.0513 1.7667 1.8028 OSR + DBH + DAU 0.6492 0.5954 0.6733 0.6039 0.7432 0.5993 0.6298 0.6537 0.6260 0.6384 OSR + DBH + DAU + DAK 0.6482 0.5965 0.6533 0.5801 0.7098 0.5602 0.5794 0.5934 0.5717 0.6022

0.0000 0.5000 1.0000 1.5000 2.0000 2.5000 Coefficient of

Variation

Figure 5.5

Local Governments Fiscal Disparities

The situation can be interpreted as follows. Since revenue decentralization is not yet applied as rigorously as expenditure decentralization, most taxing power lies within the central government’s control, as well as revenues generated from natural resources. Some parts of tax revenues and natural resource revenues are transferred back to subnational governments in the form of DBH taxes and DBH natural resources. Because of the difference in regional advantages, some subnational governments receive substantial amount of DBH taxes (like special capital territory, Jakarta) or DBH natural resources (like subnational governments in oil-rich regions of Aceh, East Kalimantan, and Riau), compared to other regions. This can further push fiscal disparity.

To promote equality in local governments’ fiscal capacity, DAU is added into the scheme.

The allocation formula of DAU takes DBH into consideration, in expectation that regions with higher DBH (relative to their fiscal needs) will not be favored with higher DAU. According to the result of CV calculation, this equalization mechanism actually works: a decrease in fiscal disparity between regions with the introduction of DAU can be observed.

Finally, there is conditional grant DAK where recipients are determined based on selection criteria, and which purpose is to encourage development in targeted sectors. It has been shown that the number of DAK recipients is increasing as well as the number of targeted sectors. CV calculation shows that DAK contributes to reducing fiscal disparities at a greater degree over the years. This situation indicates the shifting of DAK characteristics: from specific grants to equalization grants, suggesting that DAK tends to lose its specificness and becomes more equalizing.

It should be noted that the provision for salary expenditure included in the DAU formula affects the equalizing effect of DAU. Figure 5.6 below shows that the CV (that has decreased after DAU allocation) increases again after salary expenditure are accounted for. This indicates that the equalizing effect of DAU is partially offset by salary expenditure.

To put it together, the net effect of balancing funds in general is reductive to fiscal disparity among local governments, as shown by CV analysis. From the equality viewpoint, this means that balancing funds as a system equalizes local governments’ fiscal capacity. Since fiscal capacity is associated with local governments’ potential to generate revenue in order to provide standardized public services (Martinez-Vazquez and Boex 1997), more equal fiscal capacity will also equalize local governments’ potential to provide public services. The outcome of this condition is more comparable public services that can be accessed by citizens anywhere across the country.

Based on the CV results, some points to note in how balancing funds work as a system are (1) DAU and DBH work in opposite directions in reducing inequality, (2) salary expenditure reduce the equalizing effect of DAU, and (3) DAK shifts from specific to equalization grants.

The last point signifies that intergovernmental grants have lost the functions of specific grants which provide funding for capital investment to the majority of subnational governments.